Inspiration from physics for thinking about economics, finance and social systems

Friday, February 14, 2014

Wall St shorts economists

I've been remiss in not providing links to my last two Bloomberg pieces. Active web surfers may have run across them, but if not -- below is the full text of this essay from January. It looks at the question -- first raised here by Noah Smith -- of why, if DSGE models are so useful for understanding an economy, i.e. for gaining insights which can be had in no other way, no one on Wall St. actually seems to use them. Good question, I think:

****

In 1986, when the space shuttle Challenger exploded 73 seconds after
takeoff, investors immediately dumped the stock of manufacturer Morton
Thiokol Inc., which made the O-rings that were eventually blamed for the
disaster. With extraordinary wisdom, the global market had quickly
rendered a verdict on what happened and why.

Economists often
remind us that markets, by pooling information from diverse sources, do a
wonderful job of valuing companies, ideas and inventions. So what does
the market think about economic theory itself? The answer ought to be
rather disconcerting.

Blogger Noah Smith recently did an informal survey
to find out if financial firms actually use the “dynamic stochastic
general equilibrium” models that encapsulate the dominant thinking about
how the economy works. The result? Some do pay a little attention,
because they want to predict the actions of central banks that use the
models. In their investing, however, very few Wall Street firms find the
DSGE models useful.

I heard pretty much the same story in
recent meetings with 15 or so leaders of large London investment firms.
None thought that the DSGE models offered insight into the workings of
the economy.

This should come as no surprise to anyone who has
looked closely at the models. Can an economy of hundreds of millions of
individuals and tens of thousands of different firms be distilled into
just one household and one firm, which rationally optimize their
risk-adjusted discounted expected returns over an infinite future? There
is no empirical support for the idea. Indeed, research suggests that the models perform very poorly.

Economists
may object that the field has moved on, using more sophisticated models
that include more players with heterogeneous behaviors. This is a
feint. It isn’t true of the vast majority of research.

Why does
the profession want so desperately to hang on to the models? I see two
possibilities. Maybe they do capture some deep understanding about how
the economy works, an “if, then” relationship so hard to grasp that the
world’s financial firms with their smart people and vast resources
haven’t yet been able to figure out how to profit from it. I suppose
that is conceivable.

More likely, economists find the models
useful not in explaining reality, but in telling nice stories that fit
with established traditions and fulfill the crucial goal of getting
their work published in leading academic journals. With mathematical
rigor, the models ensure that the stories follow certain cherished
rules. Individual behavior, for example, must be the result of
optimizing calculation, and all events must eventually converge toward a
benign equilibrium in which all markets clear.
A creative
economist colleague of mine told me that his papers have often been
rejected from leading journals not for being implausible or for
conflicting with the data, but with a simple comment: “This is not an
equilibrium model.”

Knowledge really is power. I know of at least one financial firm in London
that has a team of meteorologists running a bank of supercomputers to
gain a small edge over others in identifying emerging weather patterns.
Their models help them make good profits in the commodities markets. If
economists’ DSGE models offered any insight into how economies work,
they would be used in the same way. That they are not speaks volumes.

Markets,
of course, aren’t always wise. They do make mistakes. Maybe we’ll find
out a few years from now that the macroeconomists really do know better
than all the smart people with “skin in the game.” I wouldn’t bet on it.

Selective Financial Services is an investment and advisory firm that strives to provide expert solutions to create lasting values, for investors, in transactions in which we invest funds, or our financial expertise, and for the companies and individuals.

Do you seek funding and the bank you deal with on a day to day basis has refused to help you?

You might qualify for our new concept and get funded with our help.Our focus is on socially responsible, green, energy producing projects. The facility is however not limited to these basics, as long as you have a strong management team, a viable business plan, and exceptional growth potential. We also enable finance for growth and consider any commercial business with the potential for a high ROI already within the first year. And we can work with any legal financial transaction offering an above average return on investment.If your requirement is within these basics, please let us have your answer to this simple question: "Would your own bank provide you with finance, if we guarantee for your loan through Deutsche Bank?"If you see chances to get funded on that basis, then you should tell us how much money you seek. We will engineer a solution for your immediate funding requirement and explain how you can put this concept to work for you.

Send an email directly to RelationshipManager@SelectiveFinancialServices.com now and visithttp://selectivefinancialservices.com/project-finance

Twitter follow

Search This Blog

Loading...

This blogexplores the potential for the transformation of economics and finance through the inspiration of physics and the other natural sciences. If traditional economics has emphasized self-regulation and market equilibrium, the new perspective emphasizes the myriad positive feed backs that often drive markets away from equilibrium and cause tumultuous crashes and other crises. Read more about the idea.

Who am I?

Physicist and science writer. I was formerly an editor with the international science journal Nature and also the magazine New Scientist. I am the author of three earlier books, and have written extensively for publications including Nature, Science, the New York Times, Wired and the Harvard Business Review. I currently write monthly columns for Nature Physics and for Bloomberg Views.